The Income Multiplier

Abstract

This note provides an overview of fiscal-policy tools and how fiscal policy influences GDP through the income multiplier. The mechanics behind the income multiplier are explained and an algebraic derivation is provided. The note also provides examples of how parameters associated with disposable income (e.g., the tax rate and marginal propensity to consumer) influence the magnitude of the income multiplier.

Excerpt

UVA-BP-0454

THE INCOME MULTIPLIER

When a government conducts fiscal policy, its objective is either to stimulate economic activity (expansionary fiscal policy) or dampen it (contractionary fiscal policy). To implement fiscal policy, the government has three primary tools at its disposal: government purchases of goods and services (G) [for example, when the government commissions a new airplane for the military], transfers (TR) [for example, social security, unemployment, or welfare payments], or taxes (T). Together, these activities constitute a government's budget position. Given that G and TR are expenditures and T represents revenues, a government's budget deficit (BD) can be written:

BD = (G + TR) – T

By altering policies that have direct bearing on one of the three components of its budget position, the government conducts fiscal policy. A government conducts expansionary fiscal policy by increasing G or TR, by decreasing T, or through some combination of the three. The ultimate objective of expansionary fiscal policy is to increase real gross domestic product (GDP) and, if the economy is far below potential GDP, then employment levels would be expected to increase without much upward pressure on the price level, meaning little chance of increasing the inflation rate. (Note: in keeping with contemporary economic convention, GDP rather than gross national product (GNP) is used in this note.) Conversely, if a government wished to conduct contractionary fiscal policy, it would decrease G or TR, or increase T. In this scenario, GDP would be expected to decline and with it inflation, and the economic contraction would be expected to lead to increases in unemployment.

A primary lesson of fiscal policy is that the government's initial act of altering G, TR, or T leads to a sequence of events that amplifies the initial policy change. For example, if a government purchases a new fighter jet for its military, the effect of this initial injection on the economy would not stop when the government handed over the check to the defense contractor. The defense contractor would turn around and pay its factors of production, for example, its employees. The spending by the government becomes someone else's income. After income taxes are deducted from the employees' paychecks, they are left with their disposable income, of which they will spend a portion on goods and services like a new TV or a dinner in a restaurant. The providers of those goods and services then pay their factors of production and so on, and so on.

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Keywords: income recognition, policy formulation, political economy